Chapter 7:
Capital Budgeting Decisions
Slides Prepared by:
Scott Peterson
Northern State University

Chapter Themes:

It’s all about rates of return.


Cash inflows and outflows are NOT the same as revenues and expenses.
A dollar today is worth more than a dollar tomorrow.
Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.
More

Chapter Themes:

It’s all about rates of return.


Cash inflows and outflows are NOT the same as revenues and expenses.
A dollar today is worth more than a dollar tomorrow.
Learning Objectives:
5.
6.
Use the payback period and the accounting rate of return methods to evaluate investment opportunities.
Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Investment decisions involving the acquisition of long-lived assets are often referred to as capital expenditure decisions because they require that capital (company funds) be expended to acquire additional resources.
Investment decisions are also sometimes called capital budgeting decisions.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Crucial to understanding capital budgeting decisions is an understanding of the time value of money. In short, the time value of money says that a dollar today is worth more than a dollar tomorrow.
Because of this we need a way to convert future dollars into their equivalent present value. Two methods for evaluating investments are discussed: the net present value method and the internal rate of return method.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Before studying these two basic methods, a brief review is in order. To convert a future value to its present value, consider the following formula:
P = F
(1 + i) n
Where:
P = the present value
F = the future value i = the rate of return
Related Learning Objectives:
1.
Define capital expenditure decisions and capital budgets.
2.
3.
4.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Before moving on, let’s say you will receive $1 exactly 1year from now. What is its present (current) value?
Assume i = 6% and use the following formula:
P = F
(1 + i) n
The answer is …
Related Learning Objectives:
1.
Define capital expenditure decisions and capital budgets.
2.
3.
4.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

… 94 Cents.
P = 1
(1 + .06) 1
Related Learning Objectives:
1.
Define capital expenditure decisions and capital budgets.
2.
3.
4.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The time value of money forms the basis of the net present value method for evaluating capital investments. As discussed in the previous chapter, recall that only incremental cash flows are relevant.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Identify the amount and time period of each cash flow associated with a potential investment. Investment projects have both cash inflows and cash outflows.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Equate or discount the cash flows to their present values using a required rate of return
(a.k.a. hurdle rate). This is the minimum return that management will accept.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Evaluate the net present value. This is the sum of all of the cash inflows and cash outflows. If the net present value (NPV) is greater than or equal to zero, the investment should be made. If less than zero, it should not be made.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

The internal rate of return method is an alternative to the net present value method. It too uses the time value of money.
Specifically, the internal rate of return (IRR) is the rate of return that equates the present value of future cash flows to the investment outlay.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Although both the net present value method and the internal rate of return method take into account the time value of money, they differ in their approach to evaluating investment alternatives.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

In the problems presented earlier, we stated a required rate of return that could be used to calculate an investment’s net present value or that could be compared with an investment’s internal rate of return. In practice, the required rate of return must be estimated by management.
Under certain conditions, the required rate of return should be equal to the cost of capital for the firm.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

To be useful in investment analysis, both the net present value methods and the internal rate of return methods require a proper specification of cash flows. In particular, remember that only cash inflows and cash outflows are discounted back to the present, not revenues and expenses.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

In the previous examples, we ignored the effect of income taxes on cash flows.
However, tax considerations play a major role in capital budgeting decisions.
Although depreciation does not directly affect cash flow, it indirectly affects cash flow because is reduces the amount of tax (which is paid in cash) a company must pay.
Thus we call these tax savings the depreciation tax shield.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Amazon.com
has yet to generate a profit. See the most recent figures here !
When companies have net losses, they can carry the losses forward and offset future income in the determination of federal income taxes. Depreciation expense in loss years will not act as a tax shield until the firm begins to show a profit, say in the year 2005.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

If inflation is ignored in net present value analysis, many worthwhile investment opportunities may be rejected. The reason is that current rates of return for debt and equity financing already include estimates of future inflation. Inflation is factored into the equation by multiplying the current level of cash flow by the expected rate of inflation.
Related Learning Objectives:
1.
2.
3.
4.
Define capital expenditure decisions and capital budgets.
Evaluate investment opportunities using the net present value approach.
Evaluate investment opportunities using the internal rate of return approach.
Calculate the depreciation tax shield, and explain why depreciation is important in investment analysis only because of income taxes.

Although the net present value and the internal rate of return methods are widely used in industry to evaluate products, many companies continue to use simpler approaches. Two of these are:
1.
payback period
2.
accounting rate of return
Related Learning Objectives:
5.
6.
Use the payback period and the accounting rate of return methods to evaluate investment opportunities.
Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

The payback period is the length of time it takes to recover the initial cost of an investment. For example, if an investment costs $1,000 and returns $500 per year, it has a payback period of 2years. There are two serious limitations with this method.
First, it does not consider cash inflows in years beyond the payback year (e. g. years
3, 4 and 5 in the example above. Second, it does not consider the time value of money.
Related Learning Objectives:
5.
6.
Use the payback period and the accounting rate of return methods to evaluate investment opportunities.
Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

The accounting rate of return
(ARR) is equal to the average after-tax income from a project divided by the average investment in the project.
ARR = Average Net Income
Average Investment
Related Learning Objectives:
5.
6.
Use the payback period and the accounting rate of return methods to evaluate investment opportunities.
Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.
Unfortunately, this method also ignores the time value of money.

An NPV greater than zero or an IRR greater than the required rate of return informs managers that an investment opportunity will increase their firm’s value.
Managers should use these techniques to maximize shareholder wealth. However, a manager’s performance
(and bonus) is often measured in the short-term on accounting income. Thus, there is an inherent conflict between what is good for the firm and what is good for the manager.
Related Learning Objectives:
5.
6.
Use the payback period and the accounting rate of return methods to evaluate investment opportunities.
Explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values.

Within the chapter, the use of the IRR method is presented for the case where cash flows are equal in all years. What if cash flows are not equal? We cannot use a single cash-flow annuity to yield a present value factor. Instead, we estimate the IRR and use the estimate to calculate the net present value of the project.
By trial-and-error, we can interpolate the actual internal rate of return.
Related Learning Objectives:
1.
Explain how the internal rate of return is calculated when there are uneven cash flows.

Appendix B: Criticisms of Time Value of
Money Approaches to Evaluating
Investments
Although methods (NPV or
IRR) employing the time value of money are preferred approaches, they have also been the subject of some criticism. Specifically critics argue that companies tend to underinvest in high-tech projects of strategic importance.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

Excessively High Required Rates of
Return Discourage Investment
Some managers set unreasonably high required rates of return because is counteracts overly optimistic cash flow projections form subordinates who want “pet projects” funded. Managers should address the real problem in these cases and follow-up on funded projects with audits of cash flows.
This way subordinates will be held accountable for their projections.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

The time value of money approach requires that all cash inflows and outflows be considered. Rather managers tend to project out only several years. The rationale is that cash flows far out in the future are highly uncertain.
As with assigning
excessively high required rates of return , this behavior
also leads to underinvestment in certain projects.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

Perhaps the most significant problem in applying time value of money approaches is that so-called soft benefits are often not taken into account. Ignoring “hard to quantify” benefits often leads to underinvestment. Consider the ERP example and the
“soft benefit” of being able to close the books in five days rather than three weeks.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

Calculating the Value of Soft Benefits
Required to Make an Investment
Acceptable
It is one thing to include soft benefits in analyzing investment opportunities but it is sometimes quite another to quantify those benefits. It may be too costly to determine those benefits.
Here, if the NPV is negative, managers should calculate the amount of additional cash inflows needed to have a positive NVC. Then, if management believes the value of the soft benefits exceeds the additional cash flows, it can decide to fund the project.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

As we have seen, time value of money approaches can lead to poor investment decisions if excessively high required rates of return are used, if cash flows far in the future are ignored, or if soft benefits are ignored. The problem lies with the misapplication of these time value methods, not the use of the method itself.
Related Learning Objectives:
1.
Discuss criticism of time value of money approaches to evaluating investment opportunities.

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